Part of Our Series on the Tax Cuts and Jobs Act of 2017
Employers generally may deduct reasonable salaries and other compensation paid to their employees. However, section 162(m) of the Internal Revenue Code imposes a $1 million annual limit on the amount of compensation that a publicly held corporation can deduct with respect to each of its “covered employees.”
The Tax Cuts and Jobs Act of 2017 substantially revises section 162(m) in ways that will significantly limit the amount of compensation that many public companies will be able to deduct.
- Scope of “Covered Employee” Expanded. Before the 2017 Act, a company had only four “covered employees” at any time: the individuals who were, on the last day of the taxable year, the CEO or one of the three other highest paid officers (but not including the CFO). The 2017 Act expands the universe of “covered employees” in two respects: (1) any individual who served as the CEO or CFO at any point during the taxable year, as well as the three other highest compensated officers for the taxable year, is a “covered employee,” and (2) once an individual becomes a “covered employee” for any taxable year beginning after December 31, 2016, that individual remains a “covered employee” for all future years, including after termination of employment or death.
- No Exception for Performance-Based Compensation and Commissions. Previously, performance-based compensation and commissions did not count toward the $1 million cap and thus generally could be deducted. The 2017 Act eliminates these exceptions so that all compensation paid to a covered employee will be subject to the $1 million limit.
- Definition of “Publicly Held Corporation” Broadened. For past years, only corporations with publicly traded equity securities were subject to section 162(m). The 2017 Act expands the definition of “publicly held corporation” generally to include (1) all domestic corporations with publicly traded equity or debt, and (2) all foreign companies publicly traded through American depositary receipts. The new definition also applies to certain companies that do not have publicly traded securities but are nonetheless subject to certain securities reporting requirements.
The new section 162(m) is generally effective January 1, 2018. However, a transition rule provides that the changes to section 162(m) do not apply to compensation provided pursuant to written binding contracts in effect on November 2, 2017, and not materially modified after that date. This creates a number of tax planning challenges, including:
- Employment Agreements. For purposes of the transition rule, (1) any contract renewed after November 2, 2017, will be treated as a new contract as of the renewal date, and (2) a contract that is terminable unconditionally at will by either party without the other’s consent (such as a typical “evergreen” employment agreement) will be treated as a new contract on the first date as of which it could be terminated without ending the employment relationship. Employers should review their existing employment, severance, change in control, and other similar agreements with their executives to determine whether the agreements are grandfathered under the pre-Act law and, if so, for how long. Employers should also make sure to consider the section 162(m) impact of any potential amendments to grandfathered agreements.
- Incentive Plans. Under prior law, stock options, SARs, and certain other equity awards were not subject to section 162(m)’s limit because they were considered to be “performance-based” by their nature. Companies will want to review their outstanding awards to determine which ones are grandfathered under prior law, and will need to carefully consider whether any amendments to these awards or the applicable equity incentive plans to preserve the grandfathering treatment to the extent desirable.
- Nonqualified Deferred Compensation Plans. Previously, benefits under nonqualified deferred compensation plans generally were fully deductible because they were typically paid after termination of employment when the individuals receiving these amounts were no longer “covered employees.” However, the 2017 Act provides that, once an individual is a covered employee he or she retains that status for all future taxable years. Thus, amounts paid under nonqualified deferred compensation plans to covered employees after termination of employment will be subject to the $1 million limit on deductibility unless otherwise excluded under the transition rule. Although the 2017 Act’s transition rule appears to be expansive in the context of nonqualified deferred compensation plans, it does not cover all nonqualified benefits, and employers should consider whether future benefits can be paid in installments to preserve deductibility.
- Severance. Similar to payments under nonqualified deferred compensation plans, severance benefits were generally fully deductible because they were paid after termination of employment when the individual was no longer a “covered employee.” Under the 2017 Act, severance payments to covered employees will generally be subject to the $1 million limit because once an individual becomes a covered employee that status now continues after termination of employment. Going forward, companies may have an incentive to spread severance pay over multiple taxable years in order to stay within the limit on deductibility.
- Proxy Disclosures. Proxy disclosure rules require companies to discuss the material elements of compensation, which may include the impact of the accounting and tax treatments of the particular form of compensation. As a result, many companies include a discussion of deductibility under section 162(m) in their proxy statements. Companies should review this disclosure and consider updating how deductibility considerations impact their executive compensation programs.
- Shareholder Approval of Incentive Plans. To satisfy section 162(m)’s exception for performance-based compensation as it existed before the Act, companies had to have their incentive plans (or at least the performance criteria in the plans) approved by shareholders, generally every five years. Companies previously planning to submit their incentive plans to shareholder approval for this purpose should consider whether to include plan approval in the upcoming proxy season unless it is otherwise required by the terms of the plan or stock exchange listing requirements.
- Plan Design. Additionally, to the extent companies’ incentive plans incorporate provisions designed to comply with section 162(m), these provisions may ultimately be revised or eliminated going forward.
Corporate Transactions. The changes to section 162(m) could raise a number of issues in the context of a merger, acquisition, or other corporate transaction. For example, changes to outstanding equity awards may remove grandfathering, newly created severance arrangements might not be deductible, and the CEO, CFO, and other officers of the acquired company might become “covered employees” of the buyer under the broad definition of that term in the Act. Companies going public should also consider the impact of these changes on their pre-IPO incentive plans.